Explaining GDP and its Value in Business FinanceARTICLE

By Bill Camarda

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When investors, policymakers, and business finance decision-makers want to understand economic performance or compare it across times or places, they often turn to a single measure: Gross Domestic Product (GDP). Casual observers may know that GDP seeks to estimate a country’s economic output, and that higher GDP growth is generally associated with a more robust economy. But GDP is a complex calculation, and some experts believe that it has many limitations.1,2 Therefore, it’s useful to understand how GDP is calculated, and what it does and does not measure.

History of GDP in Policy-Making and Business Finance

The origins of GDP are often traced back to the 1930s, when economic statistician Colin Clark pioneered the estimation of national income, first in the U.K. and then in Australia.3 In 1932, economist Simon Kuznets sought to quantify recent shifts in U.S. national income to understand the Depression’s true impact.4 Later, after World War II, the U.S. required countries to estimate GDP as a condition of receiving aid. As the use of the metric spread, the United Nations built a template for calculating GDP that has since been revised several times.5 By 1978, GDP estimates existed for over 100 countries, though there were, and remain, important differences in how countries measure GDP.6 Today, GDP plays a major role in helping to drive both national and global economic policies, as well as business finance decisions.7

What GDP Measures – and What It Doesn’t

As its name suggests, GDP measures production, not sales. So, if a car manufacturer produces an automobile in the first quarter, it counts towards first quarter GDP even if it sits unsold for months. GDP also focuses on value for “final” users: the value of wheat in a loaf of bread is counted once, not repeatedly as it’s milled into flour and eventually sold by a baker.8

Most GDP calculations also include some – but not all – “nonmarket” production. So, for example, they include government defense spending and education services, as well as emergency services provided by charities after a natural disaster. Government statisticians often need to project the “market price” of such nonmarket services.9

GDP doesn’t include unpaid childcare, housework, or eldercare services. This traditionally undervalued the economic contributions of women, while also overestimating growth as women moved from unpaid work into the workforce.10

Challenges to Calculating GDP

When it comes to calculating useful GDP data, three points are worth noting:

An economy’s overall size says little about its participants’ affluence. In 2014, the U.S.’s overall GDP was 1.7 times as large as China’s, but U.S. per capita income was 7.1 times as high.12 Hence, an assessment of a country’s living standards requires adjustment for the size of its population. But not all societies have equally accurate census data, particularly when it comes to understanding changes in GDP over several decades.13

Finally, as with any statistic, “garbage in, garbage out.” GDP estimates are only as good as the data they’re based on – and quality of that data can vary widely.

GDP Revisions Spur Worldwide Debate

In 2010, for example, Ghana revised GDP estimates to show an economy 60 percent larger: statistically, at least, it had instantly transformed from one of the world’s poorest nations to an “aspiring middle-income” country.14 Later, in 2014, Nigeria performed a similar recalculation, raising its GDP by 89 percent.15

How could this happen? Leading development economist Morten Jerven notes that statistical offices in some countries don’t have the data or resources to fully estimate GDP each year. So, he says, they extrapolate from a benchmark year when they have relatively good information. In following years, they build on the benchmark year, using whatever business finance data is available – for example, estimating construction growth from data on cement imports.16

Over time, however, economies change; these sets of “qualified guesswork and brave assumptions” become increasingly untenable, especially in economies with large informal sectors.17 When the country recalculates based on a new benchmark year, numbers can change radically. Even when the new estimates are more accurate, comparisons become extremely difficult.

When India changed its benchmark year and added new data sources, its 2013-2014 growth rate spiked from 4.7 percent to 6.9 percent.18 These new calculation methods were designed to more closely reflect best practices, but observers claimed the resulting estimates didn’t match other, less-optimistic indicators associated with economic performance and business finance.19

Shifting Factors Driving GDP Calculations

Even in developed economies, changes in methodology can be controversial. In mid-2013, the U.S. revised GDP to incorporate royalties from creative services such as Hollywood movies, along with revenue from scientific R&D – arguably improving accuracy, but also generating a one-time caffeine rush in apparent growth.20 The same year, The Economist reported, EU countries incorporated income from some illegal activities in business finance calculations. That instantly added 0.7 percent to the U.K.’s GDP, while requiring statisticians to “fall back on crude proxies” in estimating this economic activity.21

As economies evolve, measuring production can become even trickier. For example, it’s traditionally been easier to track manufacturing than services, and the disparity may be increasing. As The Economist notes, “a growing fraction of innovation is not measured [in] a world where houses are Airbnb hotels and private cars are Uber taxis, where a free software upgrade renews old computers, and Facebook and YouTube bring hours of daily entertainment to hundreds of millions” at no charge.22

Business financial services also challenge GDP statisticians. To capture value earned through interest, statisticians estimate the ‘spread’ between a risk-free interest rate and a lending rate, and multiply this by the stock of loans, according to The Economist. However, since this spread measures a bank’s risk, its use in GDP figures can have “perverse” results, the magazine said. For example, in 2009 Britain’s financial sector was experiencing serious problems. But because fear of bank defaults was driving up spreads in business finance, the sector’s contribution to GDP actually increased.23

Does GDP Measure What Matters Most?

While Paul Samuelson and fellow leading economist William Nordhaus called GDP one of the 20th century’s “greatest inventions,” not everyone has been quite so fond of it.24 Robert F. Kennedy famously complained that it measured ambulance traffic, prisons, and nuclear warheads, but not “the health of our children… the joy of their play… the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.”25

Responding to such critics, some have sought to craft alternative social measures. These range from Bhutan’s attempt to track “gross national happiness”26 to the Human Development Index (HDI), which synthesizes widely diverse metrics of economic, social, and environmental performance.27 From the standpoint of a business finance decision-maker, none of these may substitute for conventional GDP measures. But they offer a reminder of the need to be aware of what statistical tools do, and do not, measure.

The Takeaway

GDP continues to offer a rough sense of the progress of national economies, but experts say that as a tool for business finance and policy, GDP’s limitations are growing when it comes to measuring economic growth.

The Author

Bill Camarda

Bill Camarda is a professional writer with more than 30 years’ experience focusing on business and technology. He is author or co-author of 19 books on information technology and has written for clients including American Express Private Bank, Ernst & Young, Financial Times Knowledge and IBM.

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